Present Value and Future Value – Explanation of the Concept

Present Value and Future Value – Explanation of the Concept:

Learning Objectives:

Understand present value concepts and the use of present value tables.

Compute the present value of a single sum and a series of cash flows.

A dollar received now is more valuable than a dollar received a year from now for the simple reason that if you have a dollar today, you can put it in the bank an have more than a dollar a year from now. Since dollars today are worth more than dollars in the future, we need some means of weighing cash flows that are received at different times so that they can be compared. Mathematics provides us with the means of making such comparisons. With a few simple calculations, we can adjust the value of a dollar received any number of years from now so that it can be compared with the value of a dollar in hand today.

The Mathematics of Interest:

If a bank pays 5% interest, than a deposit of $100 today will be worth $105 one year from now. This can be expressed in mathematical terms by means of the following formula or equation:

Formula or Equation:

F1 = P ( 1 + r )

Where: F1 = the balance at the end of one period, P = the amount invested now, and r = the rate of interest per period.

Example:

If the investment made now is $100 deposited in a bank saving account that is to earn interest at 5%, than P = $100 and r = 0.05. Under these conditions, F1 = $105, the amount to be received in one year.

The $100 present outlay is called the present value of the $105 amount to be received in one year. It is also known as the discounted value of the future $105 receipt. The $100 figure represents the value in present terms of $105 to be received a year from now when the interest rate is 5%.

Compound Interest: When if the $105 is left in the bank for a second year? In that case, by the end of the second year the original $100 deposit will have grown to $110.25:

Original deposit

$100.00

Interest for the first year ($100 × 0.05)

5.00

——-

Balance at the end of the first year

105.00

Interest for the second year ($105 × 0.05)

5.25

——-

Balance at the end of the second year

$110.25

======

Notice that the interest for the second year is $5.25, as compared to only $5.00 for the first year. The reason for the greater interest earned during the second year is that during second, interest is being paid on interest. That is, the $5.00 interest earned during the first year has been left in the account and has been added to the original $100 deposit when computing interest for the second year. This is known as the compound interest. In this case, the compound is annual. Interest compounded on a semiannual, quarterly, monthly, or even more frequent basis. The more frequently compounding is done, the more rapidly the balance will grow.

We can determine the balance in an account after n periods of compounding using the following formula or equation:

Fn = P (1 = r)n (1)

Where n = number of periods.

If n = 2 years and the interest rate is 5% per year, then the balance in two years will be as follows:

F2 = $100 ( 1 + 0.05 )2

F2 = $110.25

Computation of Present Value:

An investment can be viewed in two ways. It can be viewed either in terms of its future value or in terms of its present value. We have seen from our computations above that if we know the present value of a sum (such as $100 deposit), it is a relatively simple task to compute the sum’s future value in n years by usingequationFn = P (1 = r)n. But what if the the tables are reversed and we know the future value of some amount but we do not know its present value?

For example, assume that you are to receive $200 two years from now. You know that the future value of this sum is $200, since this is the amount that you will be receiving after two years. But what is the sum’s present value – what is it worth right now? The present value of any sum to be received in the future can be computed by turning equation Fn = P (1 = r)n. around and solving for P:

P = Fn / ( 1 + r )n (2)

In our example, F = $200 (the amount to be received in future), r = 0.05 (the annual rate of interest), and n=2 (the number of years in the future that the amount is to be received)

P = $200 / (1 + 0.05)n

P = $200 / (1 + 0.05)2

P = $200 / 1.1025

P = $181.40

As shown by the computation above, the present value of a $200 amount to be received two years from now is $181.40 if the interest rate is 5%. In effect, $181.40 received right now is equivalent to $200 received two years from now if the rate of return is 5%. The $181.40 and the $200 are just two ways of looking at the same thing.

The process of finding the present value of a future cash flow, which we have just completed, is called discounting. We have discounted the $200 to its present value of $181.40 The 5% interest figure that we have used to find this present value is called the discount rate. Discounting future sums to their present value is a common practice in business, particularly in capital budgeting decisions.

If you have a power key (yx) on your calculator, the above calculations are fairly easy. However, some of the present value formulas will be using are more complex and difficult to use. Fortunately, tables are available in which many of the calculations have already been done for you. For example, Table 3 at Future Value and Present Value Tables page shows the discounted present value of $1 to be received two periods from now at 5% is 0.907. Since in our example we want to know the present value of $200 rather than just $1, we need multiply the factor in the table by $200:

$200 × 0.907 = $181.40

This answer is the same as we obtained earlier using the formula in equation (2).

Present Value of a Series of Cash Flow:

Although some investments involve a single sum to be received (or paid) at a single point in the future, other investments involve a series of cash flows. A series (or stream) of identical cash flows is known as an annuity. To provide an example, assume that a firm has just purchased some government bonds in order to temporarily invest funds that are being held for future plant expansion. The bonds will yield interest of $15,000 each year and will be held for five years. What is the present value of the stream in interest receipts from the bonds? As shown from the following calculations the present value of this stream is $54,075 if we assume a discount rate of 12% compounded annually.

Two points are important in connection with this computation. . First, notice that the present value of the $15,000 received a year from now is $13,395, as compared to only $8,505 for the $15,000 interest payment to be received five years from now. This point simply underscores the fact that money has a time value.

The second point is that the computations involved above involve unnecessary work. The same present value of $54,075 could have been obtained more easily by referring to Table 4 at Future Value and Present Value Table. Table 4 contains the present value of $1 to be received each year over a series of years at various interest rates. This table have been derived by simply adding together the factor from Table 3 as follows:

The sum of the five factors above is 3.065. Notice from the Table 4 at Future Value and Present Value Tables Page that the factor of $1 to be received each year for five years at 12% is also 3.605. If we use this factor and multiply it by the $15,000 annual cash inflow, then we get the same $54075 present value that we obtained earlier.

$15,000 × 3.605 = $54,075

Therefore, when computing the present value of a series (or stream) of equal cash flows that begins at the end of period 1, Table 4 should be used.